Off-Balance Sheet Financing (OBSF)
What Is Off-Balance Sheet Financing (OBSF)?
The term off-balance sheet (OBSF) financing refers to a accounting practice that involves recording corporate assets or liabilities so that doesn't make them appear on a company's balance sheet. The practice is used to keep debt-to-equity (D/E) and leverage ratios low, especially assuming that the inclusion of a large expenditure would break negative debt covenants. Off-balance sheet financing is a legal practice insofar as companies follow accounting rules and regulations. It becomes illegal assuming corporate heads use it to hide assets or liabilities from investors and financial regulators.
Understanding Off-Balance Sheet Financing (OBSF)
Companies with heaps of debt often do whatever they can to ensure that their leverage ratios do not lead their agreements with lenders, otherwise known as covenants, to be breached. All the while, a healthier-looking balance sheet is likely to draw in more investors. To meet these objectives, they might need to go to certain accounting strategies like OBSF.
Off-balance sheet financing is an accounting practice that permits companies to keep certain assets and liabilities off their balance sheets. In spite of the fact that they may not be present on the sheet, they actually belong to the business. OBSF is generally used by businesses that are exceptionally leveraged, especially when assuming more debt means a higher debt-to-equity ratio. The more debt a company has, the higher the risk of default for the lender. This means charging the company a higher interest rate.
This practice involves excluding certain capital expenditures or assets from the balance sheet. This means shifting ownership to other entities like partners or subsidiaries in which the company secures a minority claim. In that capacity, examples might include joint ventures (JV), research and development (R&D) partnerships, and operating leases. Some corporations use special purpose vehicles (SPVs) with their own balance sheets to which they transfer these assets and liabilities.
Despite the fact that it sounds sketchy, off-balance sheet financing is a legitimate and very legal practice — insofar as companies abide by established accounting rules and regulations. Companies in the United States are required to abide by generally accepted accounting principles (GAAP). The strategy becomes illegal when it is used to hide financial irregularities, similarly as with Enron.
Albeit certain transactions may not appear on a company's balance sheet, they often appear in accompanying financial statements. As an investor, it's important to read between the lines as this information may often be buried in other financial forms.
Special Considerations
There are rules and regulations in place to ensure that corporate accounting is fair and accurate. In that capacity, regulators dislike OBSF as an accounting method and are making it harder for companies to use it. Demand to make off-balance sheet financing more transparent is developing. The aim is to help investors make better and more well-informed decisions about where to invest their money. Despite the push, companies might in any case find approaches to pretty up their balance sheets proceeding.
The key to identifying red flags in OBSF is to read financial statements in full. As an investor, you should keep an eye out for words like partnerships, rental, or lease expenses and cast a critical eye over them. You may likewise need to contact company management to explain assuming OBSF agreements are being used and to determine the amount they really affect liabilities.
Off-Balance Sheet Financing (OBSF) Reporting Requirements
Companies must follow Securities and Exchange Commission (SEC) and GAAP requirements by disclosing OBSF in the notes of their financial statements. Investors can study these notes and use them to decipher the depth of potential financial issues, albeit this isn't generally just about as straightforward as it seems.
Over the years, regulators have been seeking to clasp down further on questionable financial reporting of this kind. In February 2016, the Financial Accounting Standards Board (FASB), changed the rules for lease accounting. It took action after establishing that public companies in the United States with operating leases carried over $1.25 trillion in OBSF for leasing obligations. According to the International Accounting Standards (IAS) Board, generally 85% of leases were not reported on balance sheets, making it difficult for investors to determine leasing activities and companies' ability to repay their debts.
The Accounting Standards Update 2016-02 ASC 842 came into effect in 2019. Right-of-use assets and liabilities resulting from leases are currently to be recorded on balance sheets.
Enhanced disclosures in qualitative and quantitative reporting in footnotes of financial statements are likewise now required. Additionally, OBSF available to be purchased and leaseback transactions are available.
Types of Off-Balance Sheet Financing (OBSF)
As noted above, there are a number of tools companies have at their disposal when it comes to off-balance sheet financing. Operating leases are some of the most famous ways of overcoming these issues. Here's the way this functions.
Rather than buying equipment outright, a company rents or leases it and then purchases it at an insignificant price when the lease period ends. Picking this option enabled a company to record just the rental cost for the equipment. Booking it as a operating expense on the income statement results in lower liabilities on its balance sheet.
Joint ventures and R&D partnerships are additionally ordinarily used in this type of accounting practice. When a company creates a JV or other type of partnership, it does not have to show the partnership's liabilities on its balance sheet, even assuming that it has a controlling interest in that entity.
Example of Off-Balance Sheet Financing (OBSF)
Disgraced energy goliath Enron used a form of off-balance sheet financing known as SPVs to hide piles of debt and toxic assets from investors and creditors. The company traded its rapidly rising stock for cash or notes from the SPV. The SPV used the stock for hedging assets on Enron's balance sheet.
When Enron's stock began falling, the values of the SPVs went down, and Enron was financially liable for supporting them. Because Enron could not repay its creditors and investors, the company filed for bankruptcy. Albeit the SPVs were disclosed in the notes on the company's financial documents, few investors understood the seriousness of the situation.
Features
- More stringent reporting rules are in place to give more transparency to controversial operating leases.
- Off-balance sheet financing isn't illegal insofar as companies abide by accounting rules and regulations.
- Regulators are keen on bracing down on questionable OBSF.
- Off-balance sheet financing is an accounting practice where companies keep certain assets and liabilities from being reported on balance sheets.
- This practice helps companies keep debt-to-equity and leverage ratios low, resulting in cheaper borrowing and the prevention of covenants from being breached.
FAQ
How Do You Know That a Company Uses Off-Balance Sheet Financing?
Companies are required to be transparent about their accounting practices. And demand for more transparency from accounting and financial regulators is increasing for companies to be more approaching in the manner they account for their financial situations. This means they should include notes in the entirety of their financial reporting. Despite this, some companies might find other ways of dressing up their balance sheets so it's important to pay special attention to wording like partnerships, rental, or lease expenses.
How Does Off-Balance Sheet Financing Work?
Off-balance sheet financing is an accounting strategy that companies use to move certain assets, liabilities, or transactions from their balance sheets. They might do this to draw in more investors or when they have a ton of debt yet need to borrow more capital to fund their operations. Companies with higher debt do this to get better financing rates. They might move these transactions to other entities, like a subsidiary or a special purpose vehicle with its own balance sheet, or to a partner in a joint venture. These transactions appear on other financial records. In spite of the fact that it sounds illegal, it isn't, for however long companies are transparent and follow accounting standards.
What Happened With Enron's Balance Sheets?
Enron was an American energy, services, and commodity company. The corporation hid a large number of dollars of debt and losses that it amassed from a series of failed projects and schemes from investors and analysts by utilizing special purpose vehicles and special purpose entities. These were undeniably kept off the company's balance sheets, thereby misleading board members and investors of these high-risk practices. Investors began losing confidence, which trickled down to Enron's SPVs and SPEs. Enron was forced to declare bankruptcy.
